Stock Options To The Rescue! Dollar General (DG)

| September 6, 2012 | 0 Comments

DG OptionsToday we’re going to look at a stock replacement strategy on Dollar General.  It allows you to reduce your risk and gives you upside potential. 

Here’s what happened…

Dollar General (DG) reported better than expected revenue and earnings in the second quarter.  And management raised their full year earnings forecast.  However, the shares are down more than 3% from yesterday’s high.

Here’s the deal…

DG earned 64 cents per share last quarter… a 52% increase from the 42 cents per share they made in the same quarter last year.  And sales jumped more than 10% as they opened more stores and same-store sales grew more than 5%.

Management expects DG to earn $2.77 to $2.85 per share this year… a significant increase from $2.68 to $2.78 they forecast in June.

Here’s the kicker…

The discount retailer had a strong quarter.  Their business model of selling items for under $10 in small convenient stores is working like a charm.

But investors weren’t impressed.  The stock has been under pressure since it reached a high of just over $56 in July.  And the fact that the stock is down after beating expectations yesterday is an ominous sign.

Clearly, DG has fallen out of favor with investors.

Here’s what to do now…

If you bought DG anytime in the last three months, you’re likely wondering what went wrong.  It seems like a solid growth stock with a great future.  But the stock’s recent performance hasn’t lived up to expectations.

This looks like another broken momentum stock.  The kind of stock that was yesterday’s darling but a mere afterthought for many growth investors today.  At this point, I think you’re better off replacing the stock with a call option.

This way you can limit your downside if growth investors continue to pull out of the stock.  And you still get to participate on the upside if DG recaptures its bullish momentum.    

Selling DG and buying the DG January 2013 $52.50 call option for $2.25 will reduce your risk and give you upside potential if DG finally gets back on track.

Let’s assume you bought 100 shares of DG for $52.50.  By selling your DG stock at $50.55 per share, you’re taking a loss of $195.  And it will cost you $225 to buy the January 2013 $52.50 call option.

This strategy limits your losses to the loss on the sale of the stock plus the cost of the option.  In this case, your losses are capped at $420 or 8% of your original stock purchase. 

But DG’s stock has much more risk.  Put simply, a broken momentum stock is dangerous.  They’re prone to huge swings once they’ve fallen out of favor with investors. 

It’s not out of the question to see the stack back at the 52-week low of $34.22.  That puts more than $1,800 of your original $5,250 investment at risk. 

What’s more, buying a call option gives you a chance to recoup your losses if the stock rallies before the January options expiration. 

And DG could rebound.  Look, it’s not like they had a bad quarter.  In fact, they’re coming off of a very strong quarter.  If DG recaptures the attention of growth investors, the stock could easily reach $60 by the end of the year.

The DG call option with a $52.50 strike will recoup your losses if DG reaches $56.70 at the January options expiration.  That will recoup $420 in losses and what you paid to buy the option. 

If DG regains its bullish momentum and hits $60 at expiration, you’ll pocket an additional $330 in profits.  That’s a 6% gain on your original $5,250 stock investment.  And anything above $60 will only increase your profits.

As you can see, replacing your DG stock holdings with a call option dramatically reduces your risk and gives you upside if the stock rebounds by the end of the year.

***Editor’s Note***  If you believe in the gold and silver story, then you have to check out the 2 stocks our colleague Robert Morris just released as part of his Penny Stock Breakouts service.  They’re gold and silver miners that are trading for just a few bucks a share– but offer tremendous upside.  Click here for details.

Good Investing,

Corey Williams

Tags: , ,

Category: Stock Options To The Rescue!

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.